I got asked a very good question from an entrepreneur last week

“[I am} doing an internet based start up. I have received a verbal commitment from 3 separate investors for a 1/3 each. Our initial ask is for $300,000, they have said they would like to see 25% for each portion of the investment as early investors. I am not sure if this is exactly fair and equitable for everyone involved. I also see a future round of investment to grow nationally in 3 - 5 years depending on the buzz around our company. My main questions are what is the best way to structure a seed investment like this as for as type of corporation, percentage, and dilution stipulations?”

The offer above gives the business a pre-money valuation of $100,000 and a post-money valuation of $400,000.

You can look at this question one of two ways – either by starting at the end or starting at the beginning.

An investor will want to exit the business in no more than 5 years with a projected earn out of 10x their money. That means that the business will need to achieve a sale price of $4m – which means you will probably need to be generate quality profits of around $500,000 a year (I can write about what constitutes quality profits in a later blog). However, given that you will probably dilute the initial investment (it is irrelevant if the initial investors follow on) by about 50% in my experience, their 75% will become 37.5% (and your 25% may become 12.5%) this means that 37.5% of the business needs to be worth $3m – so therefore the company needs to get a valuation of $8m and hence profits of around $1m a year.

Looking at it from the other point of view (the beginning), the question I always ask myself about the pre-money valuation is – does it accurately reflect the cost of building it from scratch. Let me give you an example based on something that happened this week.

I saw a great business plan and pitch this week, with a pre-money valuation of £5m. I asked the entrepreneur – how much it would cost me to get to the same point he was at now and he very honestly replied “about £150,000” so my obvious response was “why are you therefore asking me to pay £5m?”

Depending on who you are (in terms of background), you can get away with very high pre-money valuations because you can rightly argue that you have a ‘market value’. If you are an entrepreneur with no experience – sadly, there is no premium to pay. Recently I invested in two internet businesses – one with a pre-money valuation of £10.6m and the other at £460,000. The only difference between the two was the level of management experience – so it makes a big difference. There is also the question of how long it would take to get there – and how defensible the idea is from competitors.

In terms of dilution – my advice would be to simply look at what else is being done in your sector – talk to the experts in your field.

You can also have claw back deals. These deals stipulate that once the investor has achieved a certain rate of return, they can ‘earn’ back a certain percentage of shares. You can also have deals which give investors (or certain specified investors) their money back early – which can also trigger a claw back.

For example, if the initial investors get their money back within three years (paid for from profits – not money raised), you could ask that their shareholding drops to 10% each (they may be very happy with that as they will have had their money back and still have 10% of a business generating good profits.

Having said all of this – in this climate if you get investors in a start up situation – take the money!

I really hope this helps

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